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Risk Management in Context of

Project Financing
of Infrastructure Project

Prof. GLENN P. JENKINS


DEPARTMENT OF ECONOMICS
EASTERN MEDITERRANEAN UNIVERSITY
NORTH CYPRUS

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PROJECT FINANCE

What is Project Finance?

• No universally accepted definition of the term “Project Financing” --


different people use it in different senses.

• Project financing refers to a financing in which lenders to a project look


primarily to the cash flow and assets of that project as the source of
payment of their loans.

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Origins and Development of
Project Finance
• Project financing had its origins in the energy industry in
industrialized countries (oil & gas production loans).
• Later extended to infrastructure, transportation, mining,
utilities and large industrial projects.
• Scope further expanded to include all kinds of infrastructure
projects.
• Today even medium-scale projects (US $5 million) can use
project finance

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Development of Project Finance
1994 1996 1997
• Number of Project
Finance Transactions 50 400 380
in emerging markets
• 41% of emerging markets project finance flows between
1994 and 1998 went to Asia.

• About 75% of project finance flows worldwide went to


infrastructure and energy in 1999.

Source (IFC 1999), Capital Data Project Finance Ware (2000)

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Why Project Financing?
• Project Owners’ Perspective
– Size and cost of projects
– Risk minimization
– Preservation of borrowing capacity
and credit rating
– May be only way that enough funds
can be raised
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Private Public Partnerships in
Infrastructure
• A major new user of project financing techniques
• Infrastructure traditionally financed and managed by
governments
• Demand for infrastructure has been growing faster than
available government funding particularly in emerging
economies.
• Recent trend has been to involve the private sector in the
supply and provision of these services
• There has to be a clear benefit for both the public and the
private partners

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Main Characteristics of Suitable
Investments for Projects Financing

• The ideal candidates for project financing are capital


investment projects that
• are capable of functioning as independent
economic units,
• can be completed without undue uncertainty, and
• When completed, will be worth demonstrably more
than they cost to complete.

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Main Characteristics of Project Finance (Summary)

– Project is a distinct legal entity.


– Project assets, project-related contracts, and
project cash flows are separated to a large degree
from the sponsors.
– Sponsors provide limited or no recourse to cash
flow from other assets.
– Lenders may have recourse to their funds through
other stakeholders through various types of
security arrangements.
– Two-phase financing is common.

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The Basic Elements of a Project Financing
Lenders
Loan Debt
Raw funds repayment Purchase
materials contract(s)

Suppliers Assets comprising the Purchasers


project
Supply Output
contract(s)
Equity Returns to Cash
funds investors deficiency
Equity
agreement and
investors
other forms of
credit support 9
Prerequisites for Project
Financing

• Financial Analysis

• Economic Analysis

• Risk Analysis

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It’s All About Risk!
The key to project financing is
the reallocation of any risk away
from the lenders to the project.

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Definition of Project Completion
• Principle Categories of Risk: Pre-Completion and Post-
Completion
• Physical Completion
– Project is physically complete according to technical design
criteria.
• Mechanical Completion
– Project can sustain production at a specified capacity for a
certain period of time.
• Financial Completion (financial sustainability)
– Project can produce under a certain unit cost for a certain
period of time & meets certain financial ratios (current ratio,
Debt/Equity, Debt Service Capacity ratios)

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Management and Alleviation of Risks
Principle Categories of Risk: Pre-Completion and Post-Completion

A:Pre-Completion Risks:
Some Examples of
Ways to Reduce or Shift Risk
Types of Risks Away from Financial Institution
•Participant Risks
-Sponsor commitment to project - Reduce Magnitude of investment?
-Require Lower Debt/Equity ratio
-Finance investment through equity
then by debt

– Financially weak sponsor - Attain Third party credit support for weak
sponsor (e.g.,Letter of Credit)
- Cross default to other sponsors
•Construction/Design defects - Experienced Contractor
- Turn key construction contract

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Management and Alleviation of Risks
A:Pre-Completion Risks (cont’d):
Some Examples of
Ways to Reduce or Shift Risk
Types of Risks Away from Financial Institution

•Process failure - Process / Equipment warranties


•Completion Risks
– Cost overruns - Pre-Agreed overrun funding
- Fixed (real) Price Contract
– Project not completed - Completion Guarantee
- Tests: Mechanical/Financial for
completion
– Project does not attain - Assumption of Debt by Sponsors if
mechanical efficiency not completed satisfactorily

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B. Post-Completion Risks
Some Examples of
Ways to Reduce or Shift Risk
Types of Risks Away from Financial Institution

• Natural Resource/Raw Material


– Availability of raw materials - Independent reserve certification
- Example: Mining Projects: reserves
twice planned mining volume
- Firm supply contracts
- Ready spot market
• Production/Operating Risks
– Operating difficulty leads to - Proven technology
insufficient cash flow - Experienced Operator/ Management Team
- Performance warranties on equipments
- Insurance to guarantee minimum cash

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B. Post-Completion Risks
Some Examples of
Ways to Reduce or Shift Risk
Types of Risks Away from Financial Institution

• Market Risk
–Volume -cannot sell entire output - Long term contract with creditworthy buyers :take-
or-pay; take-if-delivered; take-and-pay
–Price - cannot sell output at profit - Minimum volume/floor price provisions
- Price escalation provisions
• Force Majeure Risks
–Strikes, floods, earthquakes, etc. - Insurance

- Debt service reserve fund

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Some Examples of
Ways to Reduce or Shift Risk
Types of Risks Away from Financial Institution

• Political Risk
–Covers range of issues from - Host govt. political risk assurances
nationalization/expropriation, - Assumption of debt
changes in tax and other laws, - Official insurance: OPIC, COFACE, EXIM
currency inconvertibility, etc. - Private insurance: AIG, LLOYDS
- Offshore Escrow Accounts
- Multilateral or Bilateral involvement
• Abandonment Risk
–Sponsors walk away from project - Abandonment test in agreement for
banks to run project closure based on historical and
projected costs and revenues
• Other Risks: Not really project risks but may include:
–Syndication risk - Secure strong lead financial institution
–Currency risk - Currency swaps / hedges
–Interest rate exposure - Interest rate swaps
–Rigid debt service - Built-in flexibility in debt service
obligations
–Hair trigger defaults
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The Need for Contracts
• Project financing arrangements invariably involve strong
contractual relationships among multiple parties.
• Project financing can only work for those projects that can
establish such relationships and maintain them at an acceptable
cost.
• To arrange a project financing, there must be a genuine
“community of interest” among the parties involved in the
project.
• In must be in each party’s best interest for the project financing
to succeed.
• Only then will all parties do everything they can to make sure
that it does succeed.

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